TMS or M3? A Reply to Paul van Eeden

A few weeks ago Paul van Eeden (PVE) posted an extremely bearish outlook on
bonds that he justified, in large part, by the rapid expansion of M3 money
supply. We responded that while we are long-term bearish on bonds (we expect
bond yields to move much higher over the coming 5 years), we thought that PVE's
premise was wrong. Our reasoning: M3 is a poor indicator of monetary inflation,
whereas a vastly superior monetary aggregate, namely the True Money Supply
(TMS) developed by Murray Rothbard and Joseph Salerno, reveals a relatively
slow rate of monetary inflation.

PVE has since responded to
our response, and in doing so has raised some good points that we'll address
in today's report. Before we do, though, it's worth noting that we never mean
any disrespect when we critique another analyst's work. In fact, we usually
won't take the time to read, let alone comment on, articles by analysts we
don't respect. Furthermore, we have absolutely no problem being taken to task
by others who consider our analysis to be off the mark, as long as the 'taking
to task' is done in an objective manner. And we certainly aren't averse to
changing our opinion when the evidence suggests that a change is appropriate.
For example, we considered M3 to be a reasonable indicator of monetary inflation
until early this year, at which time the large divergences between different
monetary aggregates prompted us to delve much more deeply into what should,
and should not, be counted in the money supply. The research we did during
the first few months of this year convinced us that a) flaws in the compositions
of M3 and MZM were causing these broad measures of money supply to generate
'major league' false signals, and b) TMS, while perhaps not ideal, was a much
better measure of money supply.

Turning our attention to the above-linked PVE article, the first thing that
deserves to be clarified is that TMS is NOT suggesting deflation. There cannot
be deflation as long as the money supply is expanding and TMS has increased
by 4.8% over the past 12 months. Also, TMS's current 12-month rate of change
is the highest since April of 2005, so TMS is increasing AND its rate of change
appears to be in the early stages of a new upward trend.

To make sure there's no doubt as to where we stand on this issue we reiterate
that we are strongly of the view -- a view consistent with the performance
of TMS -- that the US will experience inflation at varying rates for many years
to come. The current difference between M3 and TMS is not the difference between
inflation and deflation; it's the difference between extremely high monetary
inflation and moderate monetary inflation.

Next, PVE acknowledges that TMS is a better measure of MONEY supply than M3
when he states: "TMS was constructed with the intention of defining a true
monetary aggregate that could tell us something about the true nature and extent
of Americaís money supply. M3, on the other hand, includes components
of the banking system, such as money market mutual funds, that are clearly
not money and which make M3, strictly speaking, not a true "monetary" aggregate." So,
despite the to and fro it seems that we are in agreement regarding TMS's superiority
as a measure of total US money supply.

After acknowledging that TMS is the better measure of money supply, PVE goes
on to explain why he will continue to use M3. In a nutshell: he will continue
to use it because it is a better predictor of events within the real economy
and the markets.

We disagree that M3 has been the better predictor and will soon explain why,
but in any case this is a separate issue. To say that TMS is the better measure
of money supply and that M3 is the better predictor/indicator of the economy
and the financial markets is to say that changes in the supply of money aren't
the only things that affect the economy and the markets. This, of course, is
true.

We'll now deal with the contention that M3 has been a more useful economic/market
indicator.

A lot of PVE's analysis relies on long-term comparisons between money-supply
growth rates and changes in money purchasing power, with changes in money purchasing
power represented by year-over-year changes in the Consumer Price Index (CPI)
calculated by John Williams at shadowstats.com. It is quite likely that this
version of the CPI comes closer to reflecting reality than the CPI reported
by the government, but even an honest attempt to come up with a single number
that represents the economy-wide average price level will necessarily fail
because the whole concept of an economy-wide average price is nonsensical.
We've explained why in several prior reports/articles, including the one posted HERE.
Unfortunately, not everything worth measuring can actually be measured.

Because PVE's comparisons of different monetary measures and the CPI are based
on the false premise that it is possible to determine a single number that
consistently/accurately reflects changes in the purchasing power of money,
there's no need for us to specifically address the conclusions he draws from
these comparisons.

This could be a case of beauty being in the eye of the beholder, but when
we look at long-term charts showing year-over-year changes in TMS and M3 we
arrive at the conclusion that TMS has generally been a better predictor than
M3 of various economic and market-related trends. With reference to the following
charts showing the year-over-year percentage changes of TMS and M3, here's
why:

1. During 1978-1979 the TMS growth rate plunged from +8% to -5%. This suggested
that the commodity boom was close to an end, which proved to be the case. M3's
growth rate pulled back during this period, but remained fairly high and therefore
failed to signal an end to the 1970s commodity boom.

2. TMS's growth rate exploded upward between November of 1981 and July of
1983, peaking at an extraordinary rate of around 50%. This suggested that a
new inflation-fueled boom was beginning, which again proved to be on the mark
(the stock market boom began during the second half of 1982). At the same time,
there was nothing in M3's performance to indicate that monetary conditions
had gone from 'tight' to 'easy'.

By the way, to answer a question posed by PVE near the end of his article:
the explosive growth in TMS during the early 1980s was driven to a large extent
by the shifting of money from time deposits (not included in TMS) to savings
deposits (included in TMS), which was, in turn, related to the realisation
that interest rates had peaked.

3. M3's growth rate fell steadily during the first three years of the 1990s,
prompting some analysts to warn of deflation and to become very bearish on
the stock market. At the same time, TMS's powerful growth suggested that the
monetary backdrop was becoming easier and that the monetary stage was being
set for a strong stock market. TMS proved to be correct.

5. There was strong growth in both TMS and M3 during 1998-2003, leading to
the inflation-fueled booms in commodities, real estate, mortgage lending, debt
securitisation, and the emerging markets.

6. The sharp decline in TMS's growth rate during 2004-2006 suggested that
the most vulnerable of the above-mentioned inflation-fueled booms would burst.
TMS's performance is therefore consistent with what actually happened to the
real estate and credit markets. On the other hand, M3's acceleration suggested
that the real estate and mortgage-lending markets were not going to run into
major difficulties. Again, TMS transmitted the more correct message.

7. As PVE notes, TMS is much more volatile than M3. This, however, is not
a weakness of TMS because in this respect TMS is simply reflecting reality.
The sad truth is that under the current monetary system the supply of money
not only increases way too fast over the long-term, it does so in a very haphazard
and volatile way.

8. The relationship between interest rates and money-supply growth is complex
because major changes in long-term interest rates are not directly determined
by monetary inflation; they are determined by inflation expectations. For example,
there was plenty of monetary inflation during the 1980s and 1990s, but during
these two decades the main beneficiary of the inflation was the stock market
and rising stock prices are never perceived to be indicative of an inflation
problem.

As noted above, the downturn in TMS's growth rate during 2004-2006 and its
relatively minor rebound over the past 18 months pointed to problems for the
housing industry and over-extended credit providers. These problems are likely
to continue. There's also a significant risk that the reduced rate of money-supply
growth will be the catalyst for a sizeable downturn in commodity prices over
the coming months, although the commodities market, being the international
variety, is influenced by changes in GLOBAL monetary inflation. Unfortunately,
at this stage we don't have a global equivalent of TMS.